Saturday, March 21, 2015

A case where RBC works

I am a fan of John Cochrane because of his intellectual honesty. He's always very up-front and clear about what his priors and his politics are. But he almost never lets that make him tendentious (the one exception being when he is talking directly or indirectly about Paul Krugman). He goes out of his way to acknowledge alternative interpretations and the limits of knowledge.

This post on news shocks is a good example of what I mean. Cochrane reports on a paper by Arezki, Ramey, and Sheng that uses a very simple macro model to explain the economic response to big oil discoveries. Cochrane notes that the paper doesn't need a lot of the fancy friction-mining and utility-mining that are common in macro these days:

My comment was something to the effect of "this paper is much more important than you think. You match the dynamic response of economies to this large and very well identified shock with a standard, transparent and intuitive neoclassical model. Here's a list of some of the ingredients you didn't need: Sticky prices, sticky wages, money, monetary policy, (i.e. interest rates that respond via a policy rule to output and inflation or zero bounds that stop them from doing so), home bias, segmented financial markets, credit constraints, liquidity constraints, hand-to-mouth consumers, financial intermediation, liquidity spirals, fire sales, leverage, sudden stops, hot money, collateral constraints, incomplete markets, idiosyncratic risks, strange preferences including habits, nonexpected utility, ambiguity aversion, and so forth, behavioral biases, nonexpected utility, or rare disasters. If those ingredients are really there, they ought to matter for explaining the response to your shocks too. After all, there is only one economic structure, which is hit by many shocks. So your paper calls into question just how many of those ingredients are really there at all."

Cochrane himself has done a little utility-mining, in his famous habit formation model of asset pricing with John Campbell. But in general, as an opponent of government intervention in the economy, he would (I am guessing) probably rather that the economy work according to a simple RBC-style model where there are no big market failures that would necessitate countercyclical policy.

The Arezki et al. paper is a victory for that kind of simple RBC-type model. But it's a limited victory, since the fluctuations produced by oil news shocks don't look like most business cycles, and because simple models like this don't explain things like the Great Recession. Cochrane, unlike someone making a lawyerly case, goes out of his way to point this out:

Valerie, presenting the paper, was a bit discouraged. This "news shock" doesn't generate a pattern that looks like standard recessions, because GDP and employment go in the opposite direction...

Thomas Philippon, whose previous paper had a pretty masterful collection of [complex elements], quickly pointed out my overstatement. One needs not need every ingredient to understand every shock. Constraint variables are inequalities. A positive news shock may not cause credit constraints etc. to bind, while a negative shock may reveal them.

Good point. And really, the proof is in the pudding. If those ingredients are not necessary, then I should produce a model without them that produces events like 2008. But we've been debating the ingredients and shock necessary to explain 1932 for 82 years, so that approach, though correct, might take a while.

Quite true. And many bloggers or op-ed writers would not go out of their way to point this out.

Anyway, to touch on Cochrane's actual point, it's very interesting that simple RBC-type models should be so good at explaining something like an oil shock and so bad at explaining things like big recessions. This fact could lead economists toward something incredibly valuable: an understanding of the scope conditions of RBC-type models.

Scope conditions are the conditions under which a model works well. (**Physics analogy alert**) For example, we know that a model of frictionless motion works pretty well on an ice skating rink and pretty badly under the ocean. And we know exactly why. In decision theory, I personally think that experiments are starting to teach us the scope conditions of super-basic econ 101 demand theory: it works well for one-shot decisions, and not very well for dynamic situations with lots of uncertainty.

But for macro, it's inherently very hard to identify scope conditions, because there's so much going on at once that you can't get a clean comparison between the cases when a model works and the cases when it fails. That's what makes this Arezki et al. paper so interesting - it gives us a clear case (oil discovery shocks) when a mostly frictionless, very forward-looking, perfectly rational representative agent model with Econ 101 type preferences really works. That, in turn, lets us look at cases where RBC models don't work, and ask "How is this case different from an oil discovery shock?" For example, it might be a negative shock as a opposed to a positive one. It might be a shock to a different sector of the economy. It might be an immediate productivity shock instead of a news shock. Etc. Having a case where RBC models actually work helps us narrow down the list of possible reasons why they usually fail.

There will inevitably be many such differences, but they narrow down the types of models we want to consider. If a model fits the Great Recession but doesn't reduce to the Arezki et al. result when applied to an oil discovery shock, we should be skeptical that that is the right model of the Great Recession. As we accumulate more clear-cut cases like the one in Arezki et al., we increase our list of limiting cases that macro models should reduce to in well-defined limits. That in turn moves us closer to what we really want - a model that really explains why big recessions happen, and what can be done to prevent or combat them.

In other words, having a bunch of limiting cases like Arezki et al. lets us throw away macro models. I personally think that's the real problem in the macro literature - the profession lets a thousand flowers bloom, but the flowers never get cut. Clear results like this one give macroeconomists a pair of scissors.

17 comments:

You want to give macroeconomists a pair of scissors so that they can go around cutting flowers? Errr... what is this? Ikebana?

I want to give John Cochrane some miracle grow and free reign in the Garden of Government. What would he cultivate with his cash? Wouldn't you like to know.

Spending money isn't about compensating... it's about communicating. If we prevent consumers from communicating to the community what's worth cultivating... then the consequence will be a crop of crazy crap. A crop of crazy crap man!

That's odd, because what Krugman doesn't like about Cochrane is his intellectual dishonesty. I haven't been following what the big C says recently, so tell me - has he stopped with the inflation bit, and acknowledged that he was wrong?

I'm willing to believe that - similar to a model that operates in a certain sub-realm of the economics universe - Cochrane is intellectually honest in certain subsets of the universe of his commentary.

I am all in favor of testing theories against limiting cases. I suspect however that events like the Great Recession are the result of lagged second and third order effects. Reducing a model that explains the Great Recession to a first order limiting case will not be much of a test of those higher order effects.

Well, instead of utility and friction mining the paper is an example of exogeneous shock mining. Instead of the Calvo-fairy we get the news-shock fairy. News-shocks are not a panacea to solve all problems of macroeconomic theory. Right now it is a fad and a lot of economists jump on the news-shock bandwagon. I think we should wait and see if it becomes a useful tool in the toolkit of macroeconomists or if it becomes a second sunspot.

I'm just wondering what the word "works" means in this sense. Just how well does it work (compared to alternatives for instance)? It seems to me this amounts to a terms of trade shock. Shouldn't we be looking at international economics models first before we go to macro models.

But this shows exactly why Cochrane isn't relevant. We all know that really big oil shocks like 73 and 79 can throw oil importers into recession. But a couple historical anomalies do not make the phenomenon of economic cycles which have been underway as far back as we can reliably trace. Tightening and loosening of oil supply just hasn't been around long enough to plausibly be the cause of economic cycles. The business cycle is the financial cycle, period. Sure the financial cycle is influenced by technological developments, politics and resource discoveries. But there's no evidence any of those other things are cyclical. For the term "real business cycle" to hold up, there has to be something cyclical about technology, politics or resource discoveries, or some other real factor. There is not. The cycle is financial. Whoever has wasted however much of their academic careers pretending otherwise needs to write off the sunk cost and move on.